Unlike they could in the early-1990s, today's real estate pension fund managers can't rely on the rising tide of recovering property markets to generate high returns for their clients. These days, they have to be more creative. For some, that means going overseas. For others, it means taking a closer look at what previously may have been uncommon investments for pension funds. Meanwhile, the business itself is getting tougher, with industry consolidation winnowing out smaller players, and performance-based fees becoming the order of the day.

Changing role for real estate The role real estate investment plays in pension funds has varied over the course of the years, particularly with fluctuations in the marketplace, according to Paul Dolinoy, president of Atlanta-based Lend Lease Real Estate Investments Inc., currently the largest real estate pension fund adviser in the United States.

"Over time, most pension funds have typically allocated about 10% of total assets to real estate," says Dolinoy. A lot of pension funds haven't hit this level recently, though, he notes. "Allocations were lower when we hit the real estate recession of the early-1990s," according to Dolinoy. And more recently, "The higher the stock market climbs, the lower the real estate allocation goes."

Although its returns may not quite equal those of stocks, "Real estate has shown outstanding investment performance over the past five to seven years, somewhere in between fixed-income and stock instruments," says Dolinoy. The beauty of investing in real estate is that it can accommodate a number of strategies for a fund, he notes. "Real estate can provide a hedge against inflation," he says, or at the same time, "It can provide high levels of income."

Pension funds originally viewed real estate merely as a vehicle to diversify their overall investment portfolios, according to G. Andrews Smith, chairman and CEO of L&B Realty Advisors in Dallas.

Thou shalt diversify "The Employee Retirement Income Security Act of 1974 (ERISA) basically said to pension funds that 'Thou shalt diversify your portfolios'," recounts Smith. "So, when it became law, all of the sudden pension funds recognized real estate as an asset class they could invest in, and they did so purely for purposes of diversification" he says.

That approach has been largely discarded in today's marketplace. "Fewer and fewer pension funds invest in real estate for diversification, because there are now so many investment classes available to achieve that goal," says Smith. "Now, pension funds look at real estate for its absolute returns - they want to make money from it."

And at the same time, pension funds want more in the way of standout returns from their real estate investments. "They have gone from viewing a 9% to 12% return as being perfectly acceptable to wanting much higher returns," according to Smith. "Like a lot of us," he adds, "they have become addicted to high returns because of the performance of the stock market."

Stock-style returns The desire for stock market-style returns from real estate, of course, has a direct impact on what kind of real estate is attractive to a pension fund these days, says Smith. "It certainly takes you from owning a large regional mall - a great cash producer and a low-volatility investment - and puts you more into other things," he notes. These "other things" include riskier investments "like development projects," says Smith, "or other real estate assets that you can put a lot of leverage on, or do all kinds of 'financial engineering' to increase the returns."

"Real estate used to be strictly an income-oriented investment and inflation hedge for pension funds, and tended to move counter to the equity market," notes Steve Smith, managing director of global client services for LaSalle Investment Management, Chicago. That mindset changed in the mid-1990s, when real estate was in the process of rebounding from the depths of recession and generating higher returns in the process.

"At that point, real estate became an alternative investment for funds seeking to take advantage of the upswing in the market, placing it in competition with other asset classes," says Smith. Expectations of 20%-plus returns arose during this period, he notes, "and to get those kind of returns today, you have to move into higher-risk investments, such as development or land investment in the U.S. - or else move offshore."

Funds looking for higher returns from real estate have several strategies to choose from, according to Steven Corkin, managing director, AEW Capital Management, Boston, a real estate manager for pension funds and other tax-exempt institutions.

"They can seek higher returns by taking on investments with leaseup/development risk," Corkin says. "Or, they can take 'pioneering views' of markets, and be willing to put their money in them ahead of other institutions," he says, in the fashion of those who invested in Phoenix-area apartments in the early-1990s, or in Southern California office properties in 1995. Alternatively, he notes, "An increasing number of investors are looking offshore for increased returns."

Overseas angles Investing overseas is an attractive course of action for many pension fund managers these days, given the condition of the U.S. real estate marketplace, says Doug Callantine, senior managing director, Legg Mason Real Estate Services, Philadelphia.

With the stateside real estate market now enjoying a state of equilibrium, "Most fund managers recognize that the value-added/opportunistic opportunities that were once available are now limited," says Callantine. The recovery of the U.S. market has led many managers to look at international opportunities, he notes, "but, as always, there are concerns about political, event and currency risks that you have in some of these markets."

"Pension funds have now started to explore opportunities outside the U.S.," says Lend Lease's Dolinoy. "Right now, they are doing it for high returns," he notes, while in the future, they will do it for diversification. Lend Lease is one fund manager exploring these opportunities, says Dolinoy, "with a global fund that is now very active in Europe, and looking at markets in South America and Asia."

"We are taking our clients offshore for higher returns," says L&B's Smith. Western Europe as a whole is in a "recovery mode," he notes, "but it is not wildly opportunistic like some countries in Eastern Europe, South America, and Asia. Markets in the United Kingdom are in a position similar to those in the U.S., i.e., they are at equilibrium," says Smith. At the same time, he adds, "We have been investing aggressively in markets in France, Spain, Germany, Portugal, and Italy."

Paris is one western European market that is operating outside the current norm, according to Smith. "We have been buying opportunistically in Paris for two years," he reports, " and have had returns well in excess of 30%."

Public vs. private equity and debt Since the early-1970s, the majority of pension fund real estate assets have been held in the form of private equity, according to Dolinoy. But investment through public equity instruments is growing, he notes.

"The private proportion of the [pension fund] real estate equity allocation is currently typically around 85%," says Dolinoy. "But, I do believe that the public equity market will become a more significant proportion of the portfolio," he says, "and that the public/private equity allocation will come closer to 50/50 as time goes on and REITS play more of a core role."

"Long-term, REITs are here to stay, and they will take a significant position in institutional portfolios," agrees LaSalle's Smith. The REIT market was terrible in 1998, "but frankly, looks very attractive now from the investment standpoint, with attractive buying opportunities available."

On the private debt side, "Pension funds have been a little slower in investing," says Dolinoy. "Those that have been putting their money in commercial mortgages/whole loans, however, have been nicely rewarded," he notes.

"Over the past three to five years, this has been a really nice market, especially since interest rates have come down and stayed low," says Dolinoy. He adds, "Pension funds that have invested this way have enjoyed the benefits of a high fixed-income component to their portfolios, as well as very safe investments in a strong economy with strong real estate fundamentals."

Meanwhile, Dolinoy says that the public debt/CMBS arena presents pension funds with some interesting opportunities. "The different tranches [of a CMBS issue], investment grade and below, each have their own set of characteristics when it comes to income returns, first-loss positions, and other factors," he says.

Pension funds typically prefer the investment-grade tranches, notes Dolinoy. "But for those with a keen understanding of fixed-income instruments and how to structure them," he says, "there are some tremendous opportunities available in the lower tranches, as well equity-type performance in the lowest tranches."

Today's real estate pension fund manager not only has to understand each component of the entire public/private/debt/equity "investment quadrants," but also how each relates to the other, according to Steven Corkin.

"It is becoming more important to have a firm understanding of the public markets, because the workings of the public and private markets are becoming tremendously intertwined," says Corkin. "Whether or not one invests in the public market, it is very important to understand public market pricing and sentiment in order to value private real estate and understand all exit options."

Business perspectives The real estate pension fund management/advisor business is extremely competitive, according to L&B's Smith. "Real estate investments are still important parts of pension fund portfolios," he notes, "but with the stock market doing so well they are, on an actual dollar basis, small parts of the portfolios - and there is a lot of competition among managers to get those dollars."

Performance/incentive-based fees are becoming common in this business, says Smith. "Traditionally, the manager has gotten predetermined fees for acquisitions, dispositions, and asset management," he explains. But now, "Instead of just paying a fee when an asset is acquired, for example, the pension fund will pay the manager a fee that is determined sometime after the transaction, based on the performance of the asset."

"Fee structures are evolving all the time," says Paul Dolinoy. "You make money when you acquire, manage, and sell assets," he notes, "and now, layered into that, are incentive fees for meeting - and preferably exceeding - the benchmark you have set for your fund."

Meanwhile, the process of getting pension fund business is becoming more direct, with fewer intermediaries. "All business used to come via RFPs from consultants, and a lot of that still goes on," says Smith. "But the trend now is for pension funds to go direct to the managers," he says. It's a small world in some respects, "and pension funds/plan sponsors know who the folks are in the management business, and they are well able to run the process on their own."

Industry consolidation The real estate pension fund management business is one where the numbers of players are dwindling - and those that remain are growing.

"We've experienced a significant amount of consolidation in the industry during the past four years," says LaSalle's Steve Smith. Meanwhile, "Margins are such that the players are getting bigger, because it is getting more difficult for a medium-sized firm to deliver multiple services to large investors." Long-term, says Smith, "the combination of margins and where the market is going will mean that there will be some boutique firms, and some very large firms - and not a lot in between."

"There has clearly been significant consolidation over the past several years in our industry, and that is a trend we expect will continue," says AEW's Corkin. It takes larger firms to provide what pension funds need.

"To be able to understand, underwrite and invest in today's public and private real estate markets, firms are finding that they need much more in the way of research and capital market resources, as well as real estate expertise, than they did previously," says Corkin.

"Today, in this industry, you have to either be very big and be able to provide the whole range of necessary services - from investment research to environmental assessments, to operating local field offices - or else be very small and specialized," says Dolinoy.

Local field offices are an important part of how Lend Lease (and other managers) operate these days. "Over past three or four years, a lot of [managers] centralized their operations, and did fine," says Dolinoy. "But now, as the markets have moved into equilibrium, it has gotten more difficult to both find and manage appropriate real estate. This is where having a number of local offices, with local-market expertise, can really pay off."

Another strategy Lend Lease is using in a competitive marketplace is that of acquiring existing companies that complement its business. As of this writing, Lend Lease was in the process of ironing out the details of a purchase of the assets and institutional businesses of The Boston Financial Group LP, one of the largest multifamily investors in the United States.

"Boston Financial is a very focused and specialized multifamily apartment manager," says Dolinoy, "which could be of great benefit to us and our clients in achieving our multifamily investment goals." Boston Financial's investment portfolio totals $6.8 billion and includes nearly 89,000 apartment units. The two companies would have more than $30 billion in assets under management and nearly 100,000 apartment units in their combined portfolios.

Trends & outlook What's hot on today's pension fund "buy" list? "We're seeing opportunities in both downtown and suburban office," says Dolinoy. Regional malls are harder to come by, he notes, with many of them held by REITs. Meanwhile, "There is always demand for industrial warehouses," says Dolinoy. Among all the real estate product types, "They are the most recession proof - even in the tough times, you do well when you have industrial."

No matter what the product type, "We've been enjoying a very friendly marketplace in terms of being able to purchase investments," says L&B's Smith. This trend should continue for the foreseeable future, he notes, with funds paying more in cash for properties. "Leverage has been playing a big role in (pension fund real estate) investing, but with interest rates going up, we see that changing."

All in all, times are good for today's real estate pension fund managers, says AEW's Corkin. "Pension funds have become extremely comfortable with real estate playing a role in their overall allocation," he says. And as their comfort level continues to increase, "They are becoming open to new concepts when it comes to investing in real estate," says Corkin, "including entering into joint ventures with public or private operators, going international, or moving further out on the risk spectrum."